Schedularity in U.S. Income Taxation and Its Effect on Tax Distribution
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Copyright 2014 by Henry Ordower Printed in U.S.A. Vol. 108, No. 3 SCHEDULARITY IN U.S. INCOME TAXATION AND ITS EFFECT ON TAX DISTRIBUTION Henry Ordower ABSTRACT—Income tax systems in some countries follow primarily schedular models that classify income by type, match it with deductions from the same class, and compute a separate tax on each class. The United States income tax uses a global tax model under which it taxes citizens and permanent residents on their worldwide income without regard to source or character. The United States system is not purely global but includes schedular elements. This Article exposes embedded schedularity in the United States income tax in the three principal areas of investment income, personal services income, and tax free income. The Article tests whether that schedularity enhances or undercuts the tax principles of horizontal and vertical equity that underlie the development of both global and schedular tax systems in advanced economies. Horizontal equity is a straightforward principle and seems an indisputable precept. It requires that like taxpayers incur like tax burdens. The principle of vertical equity is more nuanced and departs from the principle that as one’s income increases, one can and should contribute ever larger percentages of that income to supporting governmental services. Vertical equity assumes that the wealthier one is, the less likely it is that an increased tax burden will diminish the individual’s welfare in any material way. Conversely, the less wealthy one is, the more likely it is that an increased tax burden will diminish the individual’s welfare materially. The vertical equity principle led to the development of the progressive rate structures. While the Article observes that Congress uses schedular elements to accomplish distributional policy goals, initially in order to protect progressivity, more recently schedularity has tended to increase overall regressivity in taxation. The Article concludes that United States taxation seems to be moderately schedular and that schedularity in the United States contributes to regressivity in taxation. AUTHOR—Professor of Law, Saint Louis University School of Law; J.D., M.A., The University of Chicago; A.B., Washington University. Thank you to Margaret McDermott for research assistance, Ilene Ordower for proofreading, and Professor Charlotte Crane for envisioning and organizing the conference and for her thoughtful commentary. 905 N O R T H W E S T E R N U N I V E R S I T Y L A W R E V I E W INTRODUCTION ............................................................................................................. 906 I. CAPITAL GAIN AND OTHER INVESTMENT INCOME .................................................. 910 A. Capital Gain ............................................................................................... 910 B. Qualified Dividend Income ......................................................................... 912 C. Imputed Income .......................................................................................... 913 II. INCOME FROM PERSONAL SERVICES ...................................................................... 915 A. The Earned Income Tax Credit (EITC) ....................................................... 915 B. The Regressive Social Security Tax ............................................................ 916 C. Compensation Deferrals ............................................................................. 917 D. Personal Service Income Exclusions and Horizontal Equity ...................... 918 III. EXCLUSIONS FROM GROSS INCOME ....................................................................... 920 CONCLUSION ................................................................................................................ 922 INTRODUCTION The U.S. income tax1 follows a global model.2 Global models combine income from all sources into a single taxable income computation.3 Several economically developed countries, including Sweden,4 Germany,5 and 1 The “income tax” in this Article refers to the U.S. federal income tax, subtitle A of the Internal Revenue Code of 1986, as amended, 26 U.S.C. (the Code). 2 SYLVAIN R.F. PLASSCHAERT, SCHEDULAR, GLOBAL AND DUALISTIC PATTERNS OF INCOME TAXATION 17–24 (1988) (discussing global and schedular tax systems); Eric M. Zolt, The Uneasy Case for Uniform Taxation, 16 VA. TAX REV. 39, 49–50 (1996) (“The United States’ tax system . has a nominally global tax system with schedular components.”). Some scholars follow the usage in the foreign tax credit literature and refer to schedularity as “basketing.” E.g., Leandra Lederman, A Tisket, a Tasket: Basketing and Corporate Tax Shelters, 88 WASH. U. L. REV. 557 (2011) (recommending increased usage of income baskets to prevent tax sheltering). 3 I.R.C. § 61(a) (2012) defines gross income as “all income from whatever source derived,” and I.R.C. § 63(a) defines taxable income as gross income less deductions, but, for individuals, I.R.C. § 62 generally separates business deductions from other deductions. 4 INKOMSTSKATTELAG (Svensk författningssamling [SFS] 1999:1229) (Income Tax Law), Dec. 16, 1999, as amended through Nov. 6, 2013 (Swed.) (hereinafter IL), available at https://lagen. nu/1999:1229, identifies three classes of income: Avd. IV. Inkomstlaget Tjänst (Income Class Personal Services), V. Inkomstlaget Näringsverksamhet (Income Class Trade or Business), and VI. Inkomstlaget Kapital (Income Class Capital). Sweden combines the net income from personal services and trade or business into a single tax base under 1 ch. 5 § IL, taxes the combined amount under 65 ch. 3, 5 §§ IL, and applies a separate lower rate to income from capital, 65 ch. 7 § IL. The literature refers to that type of system as a “dual income” tax. Among American scholars recommending a dual income tax for the United States, see Edward D. Kleinbard, An American Dual Income Tax: Nordic Precedents, 5 NW. J.L. & SOC. POL’Y 41, 42–43, 42 n.7 (2010), referring to separation of capital income from labor income where they overlap and citing principal English-language sources on Nordic dual income taxes. 5 Einkommensteuergesetz [Income Tax Law], Oct. 16, 1934, as amended through Dec. 18, 2013, BGBL. I, § 2 (Ger.), available at http://www.gesetze-im-internet.de/estg/BJNR010050934.html (identifying seven classes of income). 906 108:905 (2014) Schedularity in U.S. Income Taxation Canada,6 employ a schedular model of taxation that separates income and related expenses into classes and either combines the net income from different classes, but limits the deduction of loss from one class from the income of another, or computes tax separately for some classes.7 In schedular systems, income not belonging to a specific class is not taxable, while in a global system like the U.S.’s, all income purportedly is taxable. Despite its appearance, the U.S. income tax system is not purely global. Instead the income tax separates income into several classes (capital gains and losses, for example8) to which it applies differing rules and rates in the same way as schedular systems do. This Article identifies and discusses schedular features of the income tax in its treatment of investment income, personal service income, and tax-exempt income. Rather than a uniform global tax on “all income from whatever source derived,”9 the income tax aggregates several income class computations. Sometimes the income tax also seeks to match and limit deductions by income class.10 Whether a tax system is global or schedular is unimportant unless the system’s structure results in an unfair distribution of tax burdens among taxpayers. The principles of horizontal and vertical equity express a view of fair tax distribution that underlies the development of both global and schedular income tax systems in advanced economies, including the United States. Horizontal equity contemplates treating like taxpayers alike so that taxpayers with identical economic incomes11 pay equal amounts of tax.12 A global system that treats all income alike identifies identical incomes more 6 Income Tax Act, R.S.C. 1985, c. 1, § 117 (5th Supp.) (Can.), as amended through Jan. 1, 2014, available at http://laws-lois.justice.gc.ca/eng/acts/i-3.3 (identifying four classes of income). 7 PLASSCHAERT, supra note 2, at 17 (defining schedular systems as taxing various types of (net) income separately; global systems as aggregating all types of income and deductions and subjecting the aggregate net income to a single, progressive set of rates; and dualistic and hybrid systems as displaying elements of both schedular and global systems). 8 I.R.C. §§ 1222, 1(h), 1211 (2012). 9 Id. § 61. 10 Id. § 265(a)(1) (denying a deduction for the expenses of producing tax-exempt income); id. § 280A(a), (c)(1) (limiting deductions from the business use of one’s personal residence); id. § 183 (limiting deductions from income-producing hobby activities). 11 The classic Haig–Simons definition of income is “the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question.” HENRY C. SIMONS, PERSONAL INCOME TAXATION: THE DEFINITION OF INCOME AS A PROBLEM OF FISCAL POLICY 50 (1938). Professor Simons acknowledges that payments in kind and imputed value from consumption of one’s own services and property present formidable problems of valuation. Id. at 52–54; see also Robert Murray Haig, The Concept of Income—Economic